International Tax Monthly – October Issue

Commercial Pilot Fails Tests for Foreign Earned Income Exclusion

The U.S. Tax Court has held that a commercial airline pilot stationed in South Korea failed both the “tax home” and the “bona fide residence” tests that determine whether a taxpayer qualifies for the foreign earned income exclusion.

The pilot flew airplanes for Korean Air Lines (KAL) in 2011 and 2012. KAL considered him to be stationed in Incheon, Korea, which meant that Incheon was the airport he most frequently operated from.

Social Participation

During the time he spent in South Korea, he played tennis and golf and participated in dinner engagements, largely with other pilots. But he spent only about one-third of each year in South Korea and more than 40% of each year in the United States. He returned to his American home frequently during those years and spent most of his days off in the United States, where his wife and house remained. The mean length of the pilot’s stays in the United States in 2011 was 7.95 days, while the mean length of his stays in South Korea that year was 2.45 days.

He stayed in South Korea only when work required it. He always stayed in the same hotel, provided at no cost by the airline, but stayed in various rooms. He also retained his U.S. citizenship, voting registration, driver’s license, bank accounts and church membership.

On their joint tax returns for 2011 and 2012, the pilot and his wife claimed an exclusion for “foreign earned income,” which the IRS disallowed.

Failing Two Critical Tests

In order to qualify for the exclusion, a taxpayer must pass two tests:

First, his or her tax home must be in a foreign country. The general rule is that a “tax home” is located in the vicinity of a taxpayer’s regular or principal place of employment, regardless of where he or she maintains a home. The tax home is where you are permanently or indefinitely engaged to work.

If you don’t have a regular or principal place of business, your tax home may be the place where you regularly live. The tax home rule is subject to an important overriding exception — an individual isn’t considered to have a tax home in a foreign country for any period during which the individual’s “abode” is in the United States. Abode has been variously defined as a home, habitation, residence, domicile, or place of dwelling. The location of your abode often will depend on where you maintain economic, family, and personal ties.

Second, a taxpayer must pass the bona fide residence test. In this case, the court found that the taxpayer wasn’t physically present in South Korea during the “330 full days” of a 12-month period required to establish that status. The court also found that, in an eleven-factor test that it uses, eight factors weighed against a bona fide residence and just three weighed in favor.

What the Factors Require

The “Sochurek standard” sets out the following factors for determining whether a taxpayer is a bona fide resident of a foreign country:

1. Intention of the taxpayer,

2. Establishment of the taxpayer’s home temporarily in the foreign country for an indefinite period,

3. Participation in the activities of the chosen community,

4. Physical presence in the foreign country consistent with the taxpayer’s employment,

5. Nature, extent and reasons for temporary absences from the taxpayer’s temporary foreign home,

6. Assumption of economic burdens and payment of taxes to the foreign country,

7. Status contrasted to that of “transient or sojourner,”

8. Treatment of taxpayer’s income tax status by his or her employer,

9. Marital status and residence of the taxpayer’s family,

10. Nature and duration of his or her employment, and

11. Good faith in making the trip abroad; for example, it shouldn’t be for purposes of evading taxes. (Sochurek, CA 7 1962, 9 AFTR 2d 883)

The court stated that intent plays perhaps the most important part in determining the establishment and maintenance of a foreign residence. It said it wasn’t convinced that the pilot intended to be anything more than a transient in South Korea. In addition, he didn’t establish a home there for any period. His actual home remained in the United States and he returned to it as frequently as practically possible.

The court also noted that the pilot’s housing abroad was a hotel — “the quintessence of transience.” He didn’t even have a particular hotel room to call his own. Even though a taxpayer may have some limited or transitory ties to a foreign country, if ties to the United States remain strong, the court has previously held that his or her abode remained in the U.S.

Be Precise

If your employment takes you away from home for long periods, talk with your accountant to help ensure you correctly and precisely determine your tax home. You don’t want to fail the tests that could allow you to take advantage of the foreign earned income exclusion. (Acone, TC Memo 2017-162)

Court Bars Tax Deduction on Sham Transaction

A U.S. District court has determined that a United States-based bank, having been denied foreign tax credits for UK taxes paid in connection with a Structured Trust Advantaged Repackaged Securities (STARS) transaction that was held to be a sham, couldn’t deduct those taxes.

The U.S. District Court of Minnesota found that the bank had waived the issue by failing to raise it sooner — and that, even if it had been timely raised, the deduction nonetheless would have been disallowed under the sham transaction doctrine.

Note: For transactions entered into after March 30, 2010 — that is, after the time period involved in this case — the Health Care and Education Reconciliation Act added a section to the U.S. Tax Code to clarify the economic substance doctrine. Under that change, a transaction is treated as having economic substance under a conjunctive two-prong test only if, apart from federal income tax effects:

1. The transaction changes the taxpayer’s economic position in a meaningful way, and

2. The taxpayer has a substantial purpose for entering into the transaction. (That is, the taxpayer’s non-federal-income-tax purpose for entering into a transaction must be “substantial.”)

Facts of the Case

A U.S. international banking and financial services holding company engaged in a complex STARS transaction with a large UK financial services company. As part of the transaction, the U.S. bank voluntarily subjected some of its income-producing assets to UK taxes by placing them in a trust with a UK trustee. The bank offset those UK taxes by claiming foreign-tax credits on its U.S. returns.

The IRS disallowed the foreign tax credits on the ground that the STARS transaction was a sham. The case was tried before a jury, which decided that the larger STARS transaction consisted of two parts — the “trust structure,” which gave rise to the foreign tax credits, and the loan. It determined that the trust structure was a sham.

Sham Transaction Doctrine

Key in this case is the understanding that, in general, a transaction will be characterized as a sham if “it is not motivated by any economic purpose outside of tax considerations” (the business purpose test), and if it “is without economic substance because no real potential for profit exists” (the economic substance test). (IEU Indus. Inc. v. U.S., (CA 8 2001) 87 AFTR 2d 2001-2492)

This sham transaction doctrine is a way for the IRS to look beyond technical compliance with the tax code to ascertain the real nature of a transaction. Once a transaction is found to be a sham, it is disregarded for federal tax purposes. (WFC Holdings Corp. v. U.S., (CA 8 2013) 112 AFTR 2d 2013-5815)

Two Issues Identified

After the jury determined that the STARS transaction was a sham, the court gave the two parties time to discuss the verdict and figure out next steps — basically, identify the issues that still had to be resolved before a judgment could be entered. The parties identified these two issues:

1. Was the U.S. bank subject to a negligence penalty in connection with its claim of foreign tax credits, and

2. Should the loan portion of the STARS transaction be disregarded as a sham?

The court then directed the parties to submit a proposed judgment. The U.S. bank instead submitted a letter asserting that there remained one final legal issue to be resolved: Could it deduct the foreign taxes it paid despite the fact that it couldn’t receive a credit for them?

The IRS contended that the bank had waived this issue and, regardless, wasn’t entitled to a deduction.

The court agreed that the issue had been waived. It asked the parties to identify every remaining legal issue that had to be resolved before it could enter judgment, and both the U.S. bank and the IRS explicitly agreed to only the two issues noted above. At no time during the briefing and resolution of those issues did the bank notify the court or opposing counsel that there were any other legal issues to be resolved before the judgment could be entered.

The bank was aware of the issue, the court noted, as it was pleaded in an amended complaint and mentioned in a trial brief. Thus, the court reasoned, while the failure to raise the issue immediately after the verdict could have been attributable to inadvertence, “it is impossible to believe that [the bank’s] subsequent months-long silence was unintentional.”

The court also agreed with the IRS that, even if the issue hadn’t been waived, the bank wasn’t entitled to claim any tax benefits flowing from it because the trust structure was disregarded as a sham.

The bank argued that courts don’t necessarily disregard all aspects of a transaction found to be a sham, noting that, in some cases, a taxpayer can claim tax benefits on the basis of “separable, economically substantive elements” of a sham transaction. While the court agreed in principle, it found that, in this case, the trust structure was found to be a sham, and the foreign tax payments were directly connected with and made in furtherance of the trust structure.

All Arguments Foreclosed by Sham Doctrine

The bank also asserted a number of other arguments in support of its entitlement to the deduction, but the court found that these arguments were foreclosed by the sham transaction doctrine. (Wells Fargo & Co. v. U.S., 09/15/2017, 120 AFTR 2d 2017-5242)

Global NewsBits
EU Commission Wants Tech Companies to Pay Fair Share of Taxes

Digital companies in the European Union (EU) pay less than half the amount of tax that other companies pay, the European Commission said in a report.The EU needs a modern tax framework to seize digital opportunities, while also ensuring fair taxation, the report added.

Within the EU, international businesses typically pay a 10.1% tax rate while traditional companies pay 23.3%, due largely to the difficulty of taxing digital assets, which are typically internet based. This is particularly important given that more than half of the world’s top 20 companies are technology-based. The Commission stated the best solution to address this distortion would be on a global level, but in the absence of sufficient progress, the EU should move ahead alone.

Short-term solutions include:

    • An equalization tax on all untaxed of insufficiently taxed income generated from all Internet-based business activities, including business-to-business and business-to consumer, creditable against the corporate income tax of a separate lever.
    • A withholding tax on payments to digital businesses, and
  • A levy on revenues from advertisement or other services provided by digital firms.

In the longer-term, the Commission said the EU should review the notion of “permanent establishment” so that firms could also be taxed in countries where they don’t have a physical presence.

The CBO Examines Corporate Inversions

The Congressional Budget Office (CBO) recently published a report titled “An Analysis of Corporate Inversions.” As described by CBO, “a corporate inversion occurs when a U.S. multinational corporation completes a merger that results in its being treated as a foreign corporation in the U.S. tax system, even though the shareholders of the original U.S. company retain more than 50% of the new combined company.”

U.S. companies have engaged in corporate inversions since 1983. According to the CBO, concern grew in 2014 because the group of corporations that announced plans to invert that year included some that were very large with combined assets of $319 billion — more than the combined assets of all of the corporations that had inverted the previous 30 years. The reduction in companies’ worldwide tax expenses following an inversion results from changes in both U.S. and foreign tax expense, the CBO noted.

The report is divided into the following sections: strategies to reduce worldwide corporate tax liabilities; reasons corporations decide to invert; an overview of past inversions; changes in companies’ tax expense; and the effects of inversions and other international tax avoidance strategies on the corporate income tax base over the next decade.

Digital Economy Tax Challenges

Angel Gurría, Secretary-General of the Organisation for Economic Co-operation and Development (OECD), addressed the difficulties of taxing the digital economy.

At a meeting of the European Economic and Financial Affairs Council (ECOFIN) on international taxation, Gurría focused on the tax challenges occurring from the digitalization of the economy.

Through the OECD’s base erosion and profit shifting (BEPS) project, agreement has been reached that VAT should be collected in the countries of destination of e-sales and e-services. Under the destination principle, tax is ultimately levied only on the final consumption that occurs within the taxing jurisdiction. Over 100 countries are implementing the new International VAT/GST Guidelines, which are fully aligned with European Union (EU) rules.

The EU has identified the total VAT revenue declared via its Mini One Stop Shop (MOSS) as in excess of €3 billion in 2015, its first year of operation. MOSS allows you to supply the following services within the EU without the need to register in each EU country you supply to:

    • Telecommunication services,
    • Television and radio broadcasting services, and
  • Electronically supplied services

The G20 has delivered a mandate to the OECD to produce an interim report by April 2018.